Drowning in Credit
If you’re like most people, you have a couple or three credit cards – or more - hanging out in your wallet and like most people, all of your cards have balances on them that you you’re paying off slowly to be sure. Sadly, also like most people, you’re probably not really aware of how much of your hard-earned salary you’re doling out to carry all that credit.
Credit card interest ranges from a low of prime rate to 28.9%. The average rate is around 18.9%. Annual interest is calculated monthly on whatever balance is on the card on a given date.
Most cards have at least a 15 day grace period and some have as many as 25 days. This means that for the grace period, no interest is charged. This also means that if you pay your cards off every month, you are not paying any interest at all.
Unfortunately, too many of us don’t take advantage of that grace period, nor do we pay our cards out each month. What happens in those cases is that now you’re paying interest on your previous balance, your new balance AND on the interest accrued! And all that at about 19%! Here’s a quick little exercise you can do that will reveal how much money you’ve paid out in interest over the last year. Expect to be shocked: gather up your credit card statements for the last 12 months. Look for an item called Interest. Add up 12 months of interest charges. Not pretty hey? Imagine what your savings would look like were that interest going to you rather than to the credit card company. That interest is the hidden cost of using your credit cards when you don’t pay them off each month. You may also notice an item called “Annual Fee” under Other Charges.
Here are some examples of how quickly interest accrues, taken from Credit Counseling Services of Alberta at www.creditcounselling.com:
| $1,000 purchase |
|
| Credit card (19%) | Bank loan (6%) |
| After 6 months | $1,098.62 | $1,031.21 |
| After 9 months | $1,151.53 | $1,047.95 |
| After 12 months | $1,206.98 | $1,065.50 |
| After 2 years | $1,456.79 | $1,144.55 |
The only way to avoid those interest charges is to pay off your cards each month. Make sure you know when your billing cut-off date is and what your card allows as a grace period (the number of days you have before interest charges kick in on new purchases). It pays you to be really mercenary about not paying interest costs. Better you keep your money in your jeans!
As for the annual fees, if you must carry a credit card, choose cards that have no annual fees. You can always call your card company and request that the fee be discontinued. If you’re a good long-term client, they may consider it. If not, switch cards and let your card company know why you’re doing it. There’s great information and a comparison of cards and their benefits on the Financial Consumer Agency of Canada website at www.fcac.gc.ca. Look for the Credit Card Interactive Tool on the right hand side of the page.
The Credit Bureau
Every person who has credit has a credit record. In Canada, two agencies track credit records; Equifax, and TransUnion. These agencies also track applications for credit, payment histories, amounts and location of debts, bankruptcies, repayment plans, work history, address history, names and AKA (also known as) and even marriage history. All lending institutions make use of credit records in their lending decisions, so it is an excellent idea to keep a clean history.
There is no magic to keeping your record clean and there are several ways to really improve your record. First and foremost, pay at least your minimum balances and pay them on time. Secondly, do not have more credit than you need and finally, don’t rack up your credit cards to their maximums.
If you always pay at least the minimum balance on time, you’ll always have a paid and up to date notation on your bureau. Paying your cards off on time every month makes your credit record sparkle and saves you the interest costs. Other tricks are to never spend more than half of the available credit on any of your cards and to never have more than 50% of your annual salary available in credit card limits. For example, if your annual salary is $65,000, you should not have any more than $32,500 available in credit cards and you should never use more than half of that amount unless you are absolutely positively certain you will be able to pay it out at the end of the month. Incidentally, the annual interest cost on $16,250, using a simple interest calculation, and an interest rate of 18.9% is about $3100. That’s three weeks in Mexico, or 2.5 months of mortgage payments, for comparison. It is also almost a year’s worth of university tuition.
Credit worthiness is denoted by the BEACON score on your credit report. The higher this score, the better you are at managing your debt. The lowest score is 400 and the highest is 900. In my 5 years + in financial services, I’ve seen too many scores approaching the 400 mark and only two in the 800 range. Most people score between 650 and 750. Most lending institutions start feeling nervous when scores fall below 620.
Certain things will knock a score down and some things knock it down a lot. Any application you make for credit will have a small impact on your score. Having more than three forms of credit also brings a score down, although if that credit is well managed, the impact can be slight. Late payments have a much greater downward effect on a score and the later the payment, the more the score goes down. The effect of late payments is magnified if there are more than one card being paid late. Collections and bankruptcies have a very negative effect on a bureau and will affect it for as many as seven years.
One way to avoid credit ‘hits’ is not to apply for all those “You’ve Been Approved” solicitations that come in the mail. You can take it that you’re a desirable customer if you’re getting those offers, but don’t sign up for them. In respect to credit, credit cards and the health of your record, less is more.
There are two common notations on a credit record, being “R” and “I” scores. “R” refers to revolving credit, like credit cards and lines of credit. “I” refers to installment credit types, which include loans and car payments. The “Rs” and “Is” should always be followed by a 1. If there is anything other than a 1 following those letters, you should be concerned and a lender will always be. A 2 behind the letter means your payment is 30 days past due; a 3 means 60 days; a 4 means 90 days; a 5 means payments have been missed for 5 months. There is no 6, 7 or 8 but there is a 9 and that means serious trouble. An R9 or an I9 means that your item has gone to a collection agency. A bunch of 9s usually means a person is currently or has been recently bankrupt. Not a good scene.
If you have never seen your credit record or if you haven’t’ seen it for more than a year, you can and should get a copy of it. Getting a copy is simple. Go to www.equifax.ca and look for Consumer Reports in the menu. You can either order your report on line by credit card and get it immediately, or print off the request and post it for the cost of a stamp.
When you get your report, if you have questions about it, ask your lender or financial advisor to go over it with you. You may find discrepancies and occasionally there are errors, all of which should be dealt with as soon as possible. In the case of a divorce, an ex-spouse may still show on your record, a detail that is usually worth clearing up. Items that make no sense could mean there has been a theft of your identity and so should be cleared up immediately.
Good Debt/Bad Debt
In my business, I regularly meet people who are very interested in finding a low, flexible mortgage rate – a prudent search to be sure. However, with far too few exceptions, these same clients are often carrying costly balances on their credit cards but seem largely unbothered by the extremely high costs of carrying those costs month after month. It is a shocking truth that with what they pay in credit card interest over their lifetime, most people could put down a very sizeable down payment on a new house!
All this is not to say people shouldn’t have credit. There are lots of good reasons for having credit sources, including credit cards. It is critical, however, to understand how credit works and how to make it work for you. It is also really important to understand the difference between good and bad credit.
Here’s the simple description: Mortgage = accruing equity; Credit card debt = big financial hole. Good credit is related to anything that has an increasing value. For most people, that means a mortgage. Real estate almost always represents growing value. Bad credit relates to anything that won’t grow in value. That means anything purchased with credit, other than real estate, equals debts that should be dispensed with as quickly as possible.
There is a commonly held belief that a mortgage must be paid down as fast as possible. This is a good practice when you have no other debt. However, unless you are one of the very lucky few to have an at-prime rate on your cards, your credit card interest is much higher than you mortgage interest. Always pay off high cost credit first.
Secondly, according to recent Canada Housing and Mortgage figures, your home’s value will increase by anywhere from 8 – 12 % this year and more than that in some areas. This means that if your mortgage interest is in the average range of about 5 - 6%, you’re seeing an annual net gain of at least 3%. The stuff you bought on your credit cards will generally not increase in value. If you’re not paying off your credit cards, you’re seeing a huge annual income loss equal to the annual interest you’re paying on your non-growth stuff.
If you don’t own a house, all the more reason not to carry credit card debt! It is far wiser to put money into savings, perhaps with a goal of purchasing real estate, than to pay interest costs to a credit card company.
The reality is this: there is no upside to carrying costs on non-growth debt. Yes, have a credit card. There will be times when you need it. But under no circumstances should you treat your credit as an extension of your salary. Credit is a means of temporarily delaying payment for something purchased but temporarily does not mean putting off payment for two years until the cost of the item has increased 100% and its value has decreased to nothing.
Eliminating Debt
Most of us have too much available credit and too much debt on that credit. Sadly, thanks to effective marketing and advertising, the lines between “I need it” and “I want it” are greatly blurred in our culture. Not all debt is bad, but too much of it is a real problem.
The main thing is to really understand the difference between I need it and I want it. We all need a place to live and we need food and clothing but most of us don’t need a 10-room home, a closet full of designer clothes and filet mignon every night. Most people need a vehicle, but most don’t need a brand new HumVee. Once the distinctions between those two concepts is sorted out, it is much easier to finance the needs and plan for the wants.
To better balance your finances, get rid of unneeded credit. That means canceling cards if you have more than three. That also means lowering the borrowing limits on your cards. You’ve probably noticed that your credit limit increases from time to time. This is especially true for people who use their cards regularly and make regular payments but never pay their cards off. Those people’s credit card companies love them; they’re creating tons and tons of wealth through interest payments to the card companies, in addition to the annual fees those people are usually paying.
Another way of managing debt is to consolidate it. High monthly payments on several credit cards usually make it impossible for most people to pay out those cards. Consolidating debt into one lower cost payment can make a huge difference in what goes out of your pocket each month.
Consider a scenario where a working couple has a home worth $300,000 with a mortgage balance of $110,000. Their mortgage payment is $1200 a month. They also have five credit cards with a total balance owing of $50,000 and pay out $1500 a month in minimum payments. As sad as it sounds, this is not an unusual scenario. Their mortgage interest rate is 5.25% and their average credit card rate is 22.96%, meaning their average interest rate, once everything is added up and averaged, is about 14%.
This couple can consolidate their debt in two ways. They can replace their mortgage and all their debt with one secured line of credit or they can leave the mortgage in place and consolidate their credit card debt into a line of credit secured against their home. Secured lines typically carry an at-prime rate and have an interest-only minimum payment requirement.
In the first scenario, this couple replaces their entire debt – mortgage and credit cards – with a line of credit secured against their home. Most institutions will lend up to 75% of a home’s appraised value, less any mortgage owing. So for this couple, with a home worth $300,000 and a mortgage balance of $110,000, there is $225,000 of available equity in their home.
This couple owes in total, $160,000. If they replace all their debt with an at-prime line of credit, their required monthly payment on $160,000 will be approximately $700. They are currently paying out $2200 a month. If they make principle and interest payments of $1500 a month, they will effectively pay down their debt and they will free up $700 for investments, savings and perhaps a bit of fun money.
In the second scenario, the couple keeps their mortgage in place, but adds a secured line of credit of $50,000, which pays out all their credit cards. It works like this: the available equity in the home is $225,000 less the mortgage balance of $110,000. This leaves $115,000 of equity they can borrow against.
In this scenario, by consolidating their credit card debt into a secured line, they reduce the cost of their non-real estate credit to prime rate from an average of 22.96% - a drop of over 17%! Their monthly mortgage payment remains unchanged but now the required minimum payment on their other debt is $219. Yes, that’s right: $219. Now if they make monthly payments of $1000, they will rapidly pay down the debt and will have freed up $500 a month, money they can invest or save each month.
The Bottom Line
There are good reasons for using credit cards appropriately and building and maintaining an excellent credit record. Many cards come with certain types of insurance, which come in handy if you’re renting a car or buying a costly item. Points like AirMiles or Aeroplan Miles are also worthwhile to have. But that insurance and those points are very costly if you’re carrying balances and paying high interest on your cards. The key is to always remember that credit cards provide a temporary access to funds not an unlimited supply of free cash.
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